Getting In and Out of Futures Contracts

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Getting In and Outof Futures Contracts

• By Peter Lang and Chris Schafer

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Futures Contracts

• A contractual agreement, to buy or sell a
  particular commodity or financial instrument at a
  pre-determined price in the future
• Commodity wheat, oats, sugar, crude oil, heating
  oil, natural gas etc
• Financial treasury notes, bonds, etc

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Futures Positions

• Long Position the holder agrees to buy the
  contract's underlying asset at a specified price,
  with the payment and delivery to occur on the
  expiration date
• Short Position holder agrees to sell an asset at
  a specific price, with delivery and payment
  occurring at expiration.

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Futures Positions

• If both the long and short parties hold their
  contracts to the expiration date, their profits
  or losses would be determined by the price of the
  asset on the spot market
• If spot price increases long party would profit
• If spot price decreases short party would profit
• Futures contracts are a zero sum game
• When one side profits the other looses money

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Investment Reasons

• Speculation
• Investors speculate on the price changes of the
  underlying assets in futures contracts
• It is an alternative to buying or short selling
  the commodity itself

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Investment Reasons

• Hedging
• Investors are able to hedge against adverse price
  movements with futures contracts
• True hedging is done to reduce price risk, not to
  make a profit
• If an investor loses money from their investment
  in the underlying commodity, then they make up
  for it with profits from their futures contracts
  and vice-versa

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Futures Exchanges

• Futures contracts are traded on exchanges.
• Exchanges are set up as membership organizations
  with a fixed number of seats with a seat being a
  precondition for direct trading on the exchange.

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Futures Exchanges

• There are two main types of members on most
  exchanges
• Commission Brokers Buy and sell futures
  contracts for their customers. Responsible for
  most of the trading on the exchanges
• Locals Trade on the exchange from their own
  account. Normally involved in speculation or
  arbitrage situations

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Futures Exchanges

• Each exchange is responsible for standardizing
  the commodities for which it offers futures
  contracts on
• The underlying assets must have a standardized
  grade or type as well as a standardized amount

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Futures Exchanges

• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange (CME)
• Commodity Exchange (COMEX) (NY)
• Kansas City Board of Trade (KCBT)
• Mid-American Commodity Exchange (MidAm)
• Minneapolis Grain Exchange (MGE)
• New York Mercantile Exchange (NYMEX)
• Philadelphia Exchange (PHLX)

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Getting In to a Futures Contract

• Choose a commodity
• Decide on your position
• Find the exchange your chosen commodity is traded
  on
• Deal with the Clearinghouse

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Clearinghouse

• To give futures marketability, exchanges use
  clearinghouses
• Act as an intermediary
• Most exchanges have their own clearinghouse
• Makes futures contracts more attractive to invest
  in

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Clearinghouse Purposes

• Make it easier to get in and out of contracts
• Guarantee that both parties will live up to their
  end of the contract
• Collects and manages funds posted by parties
• Helps with delivery process at expiration

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Clearinghouse Position


A
CH
B
April Oil
April Oil
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Initial Margin

• Is the amount that must be deposited by the
  investor on the day the futures position is
  established.
• Can be in the for of cash or cash equivalents
• The trader does this by setting up a margin
  account with the broker and depositing the
  required amount with them
• The amount of the margin is determined by the
  exchanges margin requirement
• Usually between 3-5
• Is a percentage of the total contract value
• Reduce the chance of default.

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Marking to Market

• When there is a decrease in the account value,
  the futures traders broker has to transfer money
  through the clearing firm equal to the loss on
  the position to the broker and clearinghouse with
  the gain.

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Maintenance Margin

• Is the amount of additional funds that futures
  traders must deposit to keep the equity in their
  account equal to a certain percentage of the
  initial margin value.
• This insures that the balance in the traders
  account does not drop too low
• This is required by brokerage firms

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Margin Call

• If one did not deposit the required margin when
  their equity fell below the required amount, they
  would then receive a margin call, and would be
  required to add additional funds to their account
• If one failed to post the additional funds their
  position in the contract would be closed

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Margins

• Investors often deposit more funds than required
  by margin requirements
• Reduces the responsibility involved with
  constantly managing a futures position
• Can be done by depositing more cash or investing
  in other future funds

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Getting Out of Futures Contracts

• Settlement
• Delivery of physical asset of contract or cash in
  the case of stock index futures
• Each exchange has their rules and procedures
  governing the deliveries of contracts and
  delivery dates
• Very few futures contracts ever reach delivery

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Getting Out of Futures Contracts

• Cover Position
• Same number of contracts on the same commodity
  but with the opposite position of the original
  futures contracts
• Clearinghouse takes care of the hassle for the
  investors

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Questions?
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Review

• Question 1
• Which position benefits if the spot price
  increases?
• Long Position or Short Position?

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Review

• Answer
• Long Position

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Review

• Question 2
• What is one function of the clearinghouse?

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Review

• Answer
• Gives futures contracts marketability
• Acts as an intermediary
• Makes it easier to get in and out of futures
  contracts
• Guarantees both parties will live up to their
  side of the contract

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Review

• Question 3
• What percentage is normally required for an
  initial margin?

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Review

• Answer
• 3 - 5

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Review

• Question 4
• What is the amount of additional funds that
  futures traders must deposit to keep the equity
  in their account equal to a certain percentage of
  the initial margin value known as?

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Review

• Answer
• Maintenance Margin

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Review

• Question 5
• What are the two main reasons investors trade in
  futures contracts?

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Review

• Answer
• Speculation
• Hedging

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Review

• Question 6
• Who is responsible for standardizing the
  commodities traded on each exchange?

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Review

• Answer
• The exchange that the commodity is traded on

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Review

• Question 7
• What position are you taking when you want to
  get out of a futures contract?

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Review

• Answer
• Cover position